How to Interpret a Financial Statement

Understanding the Balance Sheet, Income Statement and Cash Flow Statement

When you are are using financial statements as a management tool, you will need to learn how to interpret them. The same accounting data is used to prepare the three key reports of the financial statement, the cash flow statement, balance sheet, and income statement, but each takes a company’s pulse in a different area.

Interpreting the Balance Sheet

The information provided here allows you to calculate several financial ratios that measure company performance. Additionally, current balance sheets should always present data from at least one previous period, so you can compare how financial performance has changed.

Identify a public company in the same industry as your startup and download their financial statements from their Web site. Using Target Corp. as an example, we’ll analyze the data in their balance sheet. Here are a few key ratios to calculate. Note that all figures represent millions of dollars.

Quick Ratio: This measures Target’s ability to meet its obligations without selling off inventory; the higher the result, the better. It is expressed as current assets minus inventories, divided by current liabilities. In Target’s case, that is 14,706 minus 6,254, divided by 11,117, which equals 0.76.

Interpretation: If this number declines over time or falls short of your benchmark, you may be investing too much capital in inventory or you may have taken on too much short-term debt.

Current Ratio: This is another test of short-term liquidity, determined by dividing current assets by current liabilities.

In Target’s case, that is equivalent to 14,706 divided by 11,117, which equals 1.32.

Interpretation: This number should be above 1, and it’s usually a sign of strength if it exceeds 2. If this number is below 1, that means your short-term liabilities exceed your short-term assets. A liability is considered current if it is due within a year. An asset is current if it can be converted into cash within a year.

Debt-to-Equity Ratio: In brief, divide total debt by total equity. In Target’s case, the denominator is termed a shareholder’s investment because Target is a public company. Using Target’s data, that ratio is expressed as 8,675 divided by 15,633, which equals 0.555.

Interpretation: Long-term creditors will view this number as a measure of how aggressive your firm is. If your business is already levered up with debt, they may be reluctant to offer additional financing.

Working Capital: This refers to the cash available for daily operations. It is derived by subtracting current liabilities from current assets, which in this example is 14,706 minus 11,117, which equals 3,589.

Interpretation: If this number is negative, that means your firm is unable to meet its current obligations. To improve this number, examine your inventory management practices; a backup of goods and the resulting loss in sales can take a toll on your business’s cash resources.

Interpreting the Income Statement

Like a balance statement, an income statement is a means for measuring a company’s financial performance. Some of the ratios discussed draw data from both the income statement and the balance sheet. We’ll continue using the published data from Target as an example. Note that all figures represent millions of dollars.

Gross Profit Margin: The money Target earns from selling a T-shirt, minus what it paid for that item—known as cost of goods sold, or COGS—is called gross profit. Sales minus COGS, divided by sales, yields the gross profit margin. According to Target’s income statement, that would be 59,490 minus 39,399, divided by 59,490, which equals 0.337, or 33.7 percent.

Operating Income: This is gross profit minus operating expenses minus depreciation. It is also called EBIT (earnings before interest and taxes).

Operating Profit Margin: Use the total derived in the previous step and divide it by total sales. In this case, the equation is 5,069 divided by 59,490, which equals .085, or 8.5 percent.

Interpretation: This tally is also known as EBIT margin and is an effective way to measure operational efficiency. If you find this number to be low, either raise revenues or cut costs. It may help to analyze which of your customers are the most profitable and concentrate your efforts there.

ROA: This stands for return on assets and measures how much profit a company is generating for each dollar of assets. Calculate ROA by dividing the revenue figure from the income statement by assets from the balance sheet. For Target, that equates to 59,490 divided by 14,706, which equals 4.04. In other words, for every dollar Target has in assets, it is able to generate $4.04 of revenue.

ROE: The same idea as above, but replacing assets with the equity. In this case, 59,490 divided by 15,633, which equals 3.81.

Accounts Receivable Collection: Many businesses experience a lag between the time they bill customers and when they see the revenue. This may be due to trade credit or because customers are not paying. While you can note this potential revenue in the balance sheet under accounts receivable, if you’re not able to collect it, eventually your business will lack sufficient cash.

Interpretation: To measure how many days it takes to collect all accounts receivable, use this formula: 365 (days) divided by accounts receivable turnover (total net sales divided by accounts receivable). In Target’s case, that equates to 365 divided by the sum of 59,490 divided by 6,194, which equals 38. This means that, on average, it takes Target 38 days to collect on its accounts. If you find your business has a healthy balance sheet but is short on cash, increase collection on outstanding accounts.

Interpreting the Cash Flow Statement

The cash flow statement discloses how a company raised money and how it spent those funds during a given period. It is also an analytical tool, measuring an enterprise’s ability to cover its expenses in the near term. Generally speaking, if a company is consistently bringing in more cash than it spends, that company is considered to be of good value.

A cash flow statement is divided into three parts: operations, investing and financing. The following is an analysis of a real-world cash flow statement belonging to Target Corp. Note that all figures represent millions of dollars.

Cash From Operations: This is cash that was generated over the year from the company’s core business transactions. Note how the statement starts with net earnings and works backward, adding in depreciation and subtracting out inventory and accounts receivable. In simple terms, this is earnings before interest and taxes (EBIT) plus depreciation minus taxes.

Interpretation: This may serve as a better indicator than earnings since noncash earnings can’t be used to pay off bills.

Cash From Investing: Some businesses will invest outside their core operations or acquire new companies to expand their reach.

Interpretation: This portion of the cash flow statement accounts for cash used to make new investments, as well as proceeds gained from previous investments. In Target’s case, this number in 2006 was -4,693, which shows the company spent significant cash investing in projects it hopes will lead to future growth.

Cash From Financing: This last section refers to the movement of cash from financing activities. Two common financing activities are taking on a loan or issuing stock to new investors. Dividends to current investors also fit in here. Again, Target reports a negative number for 2006, -1,004. But this should not be misconstrued: The company paid off 1,155 of its previous debt, paid out 380 in dividends and repurchased 901 of company stock.

Interpretation: Investors will like these last two items, since they reap the dividends, and it signals that Target is confident in its stock performance and wants to keep it for the company’s gain. A simple formula for this section: cash from issuing stock minus dividends paid, minus cash used to acquire stock.

The final step in analyzing cash flow is to add the cash balances from the reporting year (2006) and the previous year (2005); in Target’s case that’s -835 plus 1,648, which equals 813. Even though Target ran a negative cash balance in both years, it still has an overall positive cash balance due to its high cash surplus in 2004.